Wintermute discusses the design flaws of DEX: imbalanced value distribution

Author: Wintermute

Compiled by: Azuma, Odaily Planet Daily

In the world of cryptocurrency, the issuance of tokens is crucial. A successful token issuance can significantly enhance the value and influence of a protocol, bringing immense wealth to various roles within the ecosystem through airdrops.

However, in the current environment, the true potential of token issuance is often limited by the design of decentralized exchanges (DEXs) — the protocols issuing tokens cannot capture the value derived from trading activities. By having their own automated market maker (AMM) curve, protocols can more effectively capture and retain the value they create, thereby improving their economic models and enhancing the sustainability of DeFi.

Token Issuance Can Create Huge Value

The issuance of tokens is the most critical moment in the development of a protocol. If designed properly, it can create immense value for all users, contributors, investors, and even the entire community.

Value creation generally manifests in the form of airdrops, where protocols distribute tokens to users who frequently use their products. Since 2024, the five largest airdrops alone have created approximately $6.6 billion in value (not including this week's airdrops of ZKsync and LayerZero).

The subsequent price discovery process will continuously validate and reshape the airdrop recipients' expectations of the protocol's true valuation, largely determining whether they will sell their airdrop shares — and this also applies to potential buyers, deciding whether they will buy in at the first opportunity.

This game-theoretic behavior will bring massive trading volume on the first day of the Token Generation Event (TGE), benefiting both CEXs and DEXs in the process.

As shown in the figure below, both Wormhole and Starknet exceeded $1 billion in trading volume on the first day of their TGEs, and trading volume generally remains high for a period after token issuance, such as Ethena and Wormhole, where the trading volume in the first 14 days accounted for more than half of the trading volume in the first 50 days.

One thing is undoubtedly clear: the success or failure of current token issuance largely depends on the situation of listing on CEXs. Larger CEXs can provide better liquidity and user bases, helping protocol tokens gain greater exposure and achieve more effective price discovery, allowing both parties to reach a mutually beneficial arrangement.

However, in the DEX environment, protocols building liquidity pools on DEXs often need to prepay a large cost (referring to liquidity pairing) and cannot capture the value they create through DEXs.

Value Hijacking by DEXs

Currently, DEXs have largely failed to reasonably price and reward the protocols that bring them trading volume, fees, and users.

For example, 100% of the trading fees on Uniswap flow to liquidity providers, while protocols like Pancakeswap, Curve Finance, and Balancer allocate a portion of trading fees to different groups within their ecosystems — token holders, DAO treasuries, etc. However, protocols that create tokens and build liquidity pools receive nothing.

If you closely observe the composition of Uniswap's trading volume, various small governance/protocol tokens (relative to mainstream coins and stablecoins) have historically been one of the main sources of its trading volume, accounting for 30% to 40% of Uniswap's total trading volume in recent months. However, this figure may still be underestimated, as mainstream coins and stablecoins include some LSTs, LRTs, and decentralized stablecoins, whose value derives from the protocols that issue them.

Although in terms of trading volume, they are not as significant as mainstream coins and stablecoins, altcoins contribute more to fees. Since April 2023, altcoins have accounted for 70%-80% of Uniswap's monthly total trading fees, with October reaching as high as 87.7%. The market share difference between trading volume and fees for altcoins is mainly due to the 0.05% or 0.01% fee tiers typically used by mainstream coins and stablecoins, while altcoin pools commonly use 0.3% or 1% fee tiers.

As shown in the figure above, since January 2023, the dominance of altcoins in trading fees has been further reinforced. This may be partly because the number of altcoins continues to increase, and partly because various altcoin protocol teams have spent countless hours and resources maintaining communities, building products, and driving token demand. However, in this process, all fees generated from token trading are captured by DEX's LPs and do not flow to the protocol itself.

It is worth noting that some teams have attempted to recover some value by implementing buy/sell taxes on their tokens, requiring a fee to be paid for each transaction. This tax model has proven quite effective for some protocols like Unibot, bringing $36 million in revenue to their ecosystems and token holders. However, this approach also has a common drawback: it introduces greater complexity to the token contract itself and limits the team's ability to capture fees only on the tokens they deploy and control.

How to Solve the Problem? Build Your Own DEX

If leading DEXs like Uniswap hijack the value that should belong to the protocol, what should the protocol do?

One option is to launch a DEX themselves, just like Friendtech launched BunnySwap. BunnySwap is a fork of Uniswap V2 by Friendtech, primarily used to facilitate trading of its native token FRIEND.

During the forking process of BunnySwap, Friendtech made two important changes: first, the trading fee ratio flowing to FRIEND-WETH liquidity providers was set to 1.5%; second, the protocol fee income belonging to the FriendTech team was also set to 1.5%.

In the original version of Uniswap V2, you could not achieve the first point — because all liquidity pools have a fixed fee rate of 0.3%; nor could you achieve the second point — the latter is also fixed at 0.05%, with all protocol fees belonging to the Uniswap DAO treasury.

With the implementation of these changes, since the issuance of the FRIEND token, BunnySwap has helped the FriendTech team obtain $8.26 million worth of WETH from protocol fees within 35 days. Like most other airdrops, FRIEND maintained high trading volume during the early TGE, reaching $89 million on the launch day, which meant $1.7 million in protocol fees.

FriendTech is not the only protocol to recover value by building its own DEX. Since 2021, Katana has been charging a 0.05% protocol fee on all trading operations on the Ronin chain, with these fees flowing to the Ronin treasury.

Since its launch in November 2021, Katana has facilitated over $10 billion in trading volume and brought $5 million in protocol fees to the Ronin treasury. Just for the AXS and SLP tokens, Katana now accounts for about 97% of all DEX trading volume, highlighting the effectiveness of a closed ecosystem in value retention. Before Katana's launch, the AXS and SLP liquidity pools had already generated $3.8 billion in trading volume on other major DEXs, which is expected to equate to approximately $1.9 million in protocol fee losses.

New Ideas, New Challenges

Building your own AMM DEX may seem profitable, but it does bring some entirely new considerations and challenges.

In the above cases, the commonality between FriendTech and Ronin Chain/Katana is that both have built a powerful ecosystem with strict limitations and achieved subsequent capture through prior constraints — FriendTech restricted the transferability of FRIEND and provided the only interface for users to buy/sell their tokens, while Ronin Chain/Katana strongly incentivized users to migrate AXS and SLP to their dedicated chain. Therefore, for protocols, to successfully capture value, they must strictly control the value they create within their own ecosystems, as DeFi is permissionless, and without restrictions, anyone can use your token to deploy their own liquidity pool on another DEX.

Additionally, building your own AMM DEX requires extra auditing costs, time, and technical resources, and necessitates convincing users and liquidity providers to accept the associated risks.

Finally, building your own AMM DEX also means losing some network effects. For example, if your token only has one X-WETH liquidity pool, it means that all potential buyers must purchase WETH before buying that token, especially before other aggregators integrate your DEX, which will inevitably affect the token's exposure.

Fortunately, the DEX space is quietly changing. Balancer has announced their V3 version, and Uniswap V4 is also on the way, both promising to achieve highly customizable liquidity pools. Specifically, the hooks architecture of Uniswap V4 will allow liquidity pool creators to add additional trading fees and treat them as another form of protocol fees. This will enable protocols to capture a certain value they create while enjoying the security and liquidity network effects of Uniswap.

Conclusion

In summary, the current DEX environment has failed to appropriately incentivize protocols for the value they bring to their platforms.

By building their own DEX, protocols can avoid the value hijacking that occurs when relying on third-party DEXs. The cases of BunnySwap and Katana demonstrate that protocols can achieve value retention by building their own AMM solutions.

While this also brings some new challenges, such as the need for additional auditing resources or introducing new risks, the potential benefits in value retention and ecosystem control still make it an attractive solution.

As the DeFi industry continues to evolve, protocols may increasingly consider controlling their own AMM curves to ensure longer-term sustainability.